Default funds with high charges should not be permitted in the new auto-enrolment market; otherwise millions of employees will suffer, the Pensions Institute has concluded in a new report.

The research, entitled 'Caveat Venditor: The brave new world of auto-enrolment should be governed by the principle of seller not buyer beware', examined the default funds, which an estimated 90-97% of private sector employees will use under auto-enrolment, and found serious flaws with the continued use of older funds with 'toxic' charges.

The key findings of the research , which was sponsored by NOW: Pensions and carried out by the Pensions Institute at Cass Business School, could be summarized in seven points:

1. There is a 100% difference in the pensions members achieve between the lowest and highest charging defined contribution (DC) default funds.

2. An estimated 90-97% of employees auto-enrolled into DC schemes will use the default fund, which means that their pension outcomes will be a lottery unless the government, regulators and industry ensure all members benefit from default funds that offer good value for money relative to contributions paid.

3. Employees do not choose their employer based on the quality of the pension scheme. Nor do they have any influence over the charges and asset management quality of the schemes their employers provide.

4. Employees are passively auto-enrolled. They are not knowingly financial services 'customers'; instead they are 'buying blind'. Therefore the Financial Services Authority's Treating Customer Fairly (TCF) approach, which is based on caveat emptor (let the buyer beware) is not appropriate. Instead, caveat venditor (let the seller beware) is the appropriate principle for auto-enrolment.

5. Charges for default funds in large new auto-enrolment schemes generally represent good value, but tens of thousands of employees currently are trapped in the funds of older schemes with high and disguised charges.

6. There is a very real danger that smaller employers will use these older schemes for auto-enrolment, potentially bringing millions of new pension investors into poor value default funds.

7. This is because the unintended consequences of the combination of auto-enrolment and the retail distribution review (RDR), which bans advisor sales commission on new schemes sold from 1 January 2013, has resulted in an advice gap in the smaller employer market. At present, there is no mechanism to prevent the use of high-charging default funds for auto-enrolment.

Professor David Blake, director of the Pensions Institute, said: "Fortunately there is time to address the problem of old high-charging funds, which for historic reasons are still widely used in the smaller employer market. These employers are not required to introduce auto-enrolment immediately but many companies will need to be prepared by mid- to late-2013.

"This report recommends the introduction of a kite-mark code that can help these employers find value for money schemes – and this is especially important if the employer is considered uneconomic ('polluted' in the industry's language) for the advisory and provider market. A clearly signposted kite mark website for good quality value-for-money schemes – available to all employers, irrespective of their size and employee profile – would facilitate fair and equal treatment for all private sector employees, irrespective of how much they earn and the company for which they work."

Chris Daykin, trustee director of NOW: Pensions, the sponsor of the research, said: "'Caveat Emptor' or 'let the buyer beware' – the normal assumption that applies to the way financial services products are purchased – simply does not work for auto-enrolment because the buyer is the employer but the real customer – who is passively auto-enrolled – is the employee. As the report states the "customers" are therefore "buying blind". Caveat Venditor represents a more appropriate principle for members of auto-enrolment DC default funds, because, as the report concludes – 'let the seller beware' – puts the onus on the seller to ensure its product will do what it says on the tin: to produce a lifetime income in retirement that is fair value relative to the contributions paid."

Also commenting on the research was Morten Nilsson, CEO of NOW: Pensions, who said: "We recognise that policy and regulatory reform takes time, particularly if it requires consultation between the government, regulators and the pensions industry. However time is running out. It is essential the auto-enrolment market is fit for purpose for all employees, not just those who are employed by large companies with good advisers. The report helps to define what a good default fund should look like. An effective and well-promoted kite mark would help employers make the right choice of default fund and scheme going forward, as well as help eliminate poor practice relating to charges and investment governance."

The full report can be accessed here.

First published 11.10.2012

azeevalkink@wilmington.co.uk